This is not 2011 or 2016 - It's different this time. No, really.
After a 10% rally in 10 days, sparked by a more dovish Fed chairman and a coordinated effort by the “Plunge Protection Team” at the behest of Treasury Secretary Mnuchin, many of the most bearish Wall Street pundits have quickly turned bullish, and are now convinced the S&P 500 crash in Q4 was simply another shallow bear market, now complete, similar to the mini-crises in 2011 and 2016. Nothing like price to change sentiment!
We beg to differ, and believe that unlike 2011 and 2016, a 20% decline in stocks will NOT mark the bottom for this cycle, and that the recent rally is simply a beguiling trap for the bulls in classic bear market fashion. Given the factors outlined below, and discussed in more depth in the following pages, here is why we believe this initially shallow bear market will likely evolve into a much more painful affair in the coming months and years.
- Technical: The technical price damage has been far greater this time than in either 2011 or 2015-16. We have not witnessed monthly or quarterly equity declines of the magnitude we saw in Q4 and December since the GFC of 2008. The importance of this impulsive and violent action cannot be understated.
- Monetary: While 20% SPX declines in 2011 and 2016 were quickly met with large liquidity injections by global central banks, this time the Fed, ECB, BOJ and PBoC have so far been less reactive to a similar drop in stocks. Since the December crash, only the PBoC has added to its balance sheet, providing far less liquidity to the system than what bulls might have hoped for. While Fed Chair Powell certainly calmed markets last week by saying the FOMC will be vigilant for economic weakness and flexible with policy, including with the balance sheet reduction program, the fact remains that the Fed is still reducing its balance sheet, draining more liquidity from an already tight environment for financial conditions. If they did not reverse course on quantitative tightening after a 20% market crash last month, we expect that the catalyst forcing them to do so will take place at much lower levels for stocks and corporate credit. Watch what they DO, not what they SAY. So far, they have done nothing, which is the direct result of internal concern over unsustainable and unhealthy sovereign debt levels. Behind the scenes, the Fed is prepping for economic war with the East who is determined to erode the “exorbitant privilege” of the US Dollar’s reserve currency status. They must defend this status at all costs, and they clearly feel a sense of urgency to get our financial house in order ahead of the battles to come.
- Fundamental: Risk for corporate credit and equity markets is higher than in 2011 and 2016 from a fundamental perspective, mainly due to higher leverage concurrent with higher interest rates. This has already created stress for companies facing significant downward earnings revisions and peaking margins in 2019. Making matters worse, the chicanery of financial engineering through debt-enabled stock buybacks and M&A will be much more difficult moving forward now that corporate credit markets are finally showing signs of real stress and investor outflows. In fact, for the first time in years, there were exactly ZERO high-yield debt deals issued in December. Les jeux sont faits.
- Sentiment: After so many years of coordinated global central bank manipulation of financial assets, price discovery has become a relic of the past, and market psychology has shifted to a dogmatic belief in passive indexing and closet trend following strategies (Risk Parity, Vol Targeting, Etc). While this dynamic worked incredibly well and contributed to leveraged stock market momentum during the historic bull market of the last decade, this knife cuts both ways, and investors will not be prepared for the downward selling momentum and deleveraging that will occur once the new bear market trend has been fully established. As in every cycle, the financial market “innovations” which led to such outsized returns during the upswing are almost always responsible for the crisis in the downswing. Make no mistake, this long overdue unwind could be catastrophic.
Technical Damage - Bear Market Confirmed
Heavy damage late in the year for stocks is abnormal behavior and tends to have an outsized impact on forward performance, since the Nov-Dec period is typically a bullish affair. That was obviously NOT the case in 2018, as December experienced an impulsive free-fall all the way into Christmas. We studied similar late-year SPX plunges from the past, and discovered that after Nov-Dec losses of over 4%, forward returns have been remarkably bearish, leading to significant bear market action within 2 years of the event. To put the magnitude of this disturbance in perspective, the -9.2% drop last month marked the worst December since the Great Depression, and the -14% Q4 tumble was the largest quarterly decline for the S&P 500 since the 2008 financial crisis. While a strong bounce from such oversold conditions is reasonable to expect (and indeed is happening right now), the type of damage that occurred last month is not often overcome easily or quickly, and we suspect that the December lows will at least be retested, and more probably taken out in the weeks ahead.
Volatility Is Contagious
In early December, the S&P 500 performed a feat it had not done since the crisis of 2008, and the early 1970’s before that. In 3 consecutive weeks, the SPX was down over 3.5%, then up over 3.5%, and then down over 3.5% yet again. Such extreme volatility over such a short time span is classic Bear Market action, and indeed this event signaled the worst of the December crash in advance. That said, the carnage that such volatility like this tends to precede suggests the worst is still yet to come. Notice that after such signals in the past, forward 6-month returns for the SPX are down over 10% on average, with 10 of the 11 instances in negative territory. As one might expect, the vast majority of these prior volatile events took place during historically painful bear markets. And in case it’s not clear by now, we are still in a Bear Market.
The Liquidity, Stupid
It's all about global liquidity, period. Since the Global Financial Crisis, the world’s largest central banks have all been working from the same playbook: flood the global financial system with enough liquidity via Zero Interest Rate Policies and Quantitative Easing to inflate asset prices. Given the massive asset price inflation we’ve seen since the market bottomed in 2009, it’s safe to say this strategy has worked very well (despite myriad unintended consequences that will prove disastrous in the future, but that’s another story). Since this grand monetary experiment began, stock prices have moved in lockstep with global central bank balance sheets, up and down. When asset prices have experienced heavy damage, central banks have come to the rescue with more liquidity during each mini-crisis. In 2011, during the European Sovereign Debt Crisis, the ECB was quick to promise “whatever it takes” in order to assure investors that liquidity would be there in spades, and backed up those comments with a massive asset purchase program. In response to the late 2015 / early 2016 stock and corporate credit swoon, global central banks forged a secret “Shanghai Accord” where the US immediately halted planned rate hikes while foreign central banks quickly piled more assets onto their balance sheets, drenching the market with the liquidity it so desired. Voila, crisis averted.
As 2018 unfolded, global financial conditions tightened considerably. The Federal Reserve finally began reducing its balance sheet in January, while the FOMC continued to raise the Federal Funds Rate as planned. This active drain on liquidity was occurring just when the ECB and BOJ were undertaking tapering programs of their own. As liquidity became more scarce late in the year, asset prices reflected more stress. Stocks crashed, bond yields spiked, corporate credit spreads widened and the US Dollar made new highs.
So why can’t the Fed and other global central banks just run the same game and pump more liquidity into the system again to fix this? The short answer is: they probably will, but only when fully backed into a corner. The better questions are when will they do it this time, from what level, and will it work as effectively as it has in the past, or will this next iteration of irresponsible debt monetization finally lead to the endgame of lost confidence in global central planning? We suspect the latter, and that the endgame is finally near.
At this point, it is critical that we watch what central banks DO as opposed to fretting about what they may SAY. While Fed Chair Powell mentioned last week that the Fed will be prudently flexible with rate hikes (our guess is they won’t raise again at all), the markets went absolutely ballistic when he backtracked on the “the balance sheet roll-off is on autopilot” comment he made post the December FOMC meeting. Bulls were thrilled to hear that the Fed will remain open to halting asset sales if financial conditions warrant it.
There’s just one problem with that: while the Fed CAN and MAY alter the balance sheet reduction program, as of right now, they are NOT changing anything. Until they officially make that policy change, the liquidity noose will continue to tighten around the market’s neck, and asset prices will remain under stress. We have no doubt that the Fed will eventually be forced to reverse the balance sheet unwind, but we don’t expect that to happen until stock prices and corporate credit are in FAR worse shape than today. We will of course be prepared to adjust our short-term tactics if it becomes clear that central planners are actually flooding the system again, but until that becomes evident, the path for risk assets should remain a treacherous one, and we still expect stocks will make new lows in the months and weeks ahead.
The Correlation Between Stocks and Central Bank Balance Sheets Is Explicit
After a decade of extremely accommodative policy, the Federal Reserve finally began shrinking its balance sheet in January 2018. The initial liquidity drain quickly produced the February Volatility Shock, and ultimately led to the market crash in Q4 as monetary conditions tightened further. However, even though the stock market dropped a similar amount compared to 2011 and 2016, the Fed did not alter its balance sheet reduction program, nor did global central banks agree to a coordinated liquidity injection as was the case with those prior mini-crises. If a 20% crash last month led to only dovish lip service from Jay Powell but no concrete action, we believe that the Fed will remain committed to its balance sheet reduction program unless stocks and bonds succumb to much lower prices.
To illustrate the difference between now and the 20% crash of 2016, note that in accordance with the “Shanghai Accord,” the Fed immediately put the breaks on rate hikes while global central banks piled on more assets (the aggregate balance sheet spiked up 5% in just a few weeks time). This was a big shift in global policy and it happened very quickly. This time, while the aggregate central bank balance sheet has risen slightly since December, it has been very modest, and only supported by the PBoC, since both the ECB and BOJ are currently winding DOWN asset purchase programs. At this point, it certainly does not feel like a coordinated global liquidity injection has been agreed to by central planners, as was the case in 2011 and 2016. Without such an injection, we expect this recent stock rally to fade quickly. Trade accordingly, and as always, stay thirsty my friends.
(PS - Shout out to Chris Carolan for the great combined global CB balance sheet charts)
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